Tail Risk And A Trip Back To The Shrinking Playground

And so it came to pass that everyone wasn’t completely stupid to put “bond crash” at the top of their “biggest worries” list for 2018.

And so it also came to pass that everyone wasn’t completely stupid to cite “inflation moves significantly higher” as an “underappreciated tail risk” in the new year.

Of course calling the Treasury selloff a “crash” is a bit hyperbolic and we’re not the kind of people that would ever traffic in crazy ass, over-the-top, tremendous, bombast. “Believe me.”

No, actually we use hyperbole all the time. The difference between our hyperbole and that which emanates from other blogs is that we’re usually half-joking and don’t fancy ourselves an actual news wire, with the latter admission freeing us up to editorialize as we see fit without inducing the same kind of eye rolling that other portals elicit by virtue of pretending to be “news” when in fact they just aren’t.

Anyway, back to the bonds, what we’ve seen recently isn’t completely out of step with historical precedent – at least in terms of nominal yields. Have a look at this brief history via Deutsche Bank:

Of course the “bad” news is that if this ends up approximating recent selloffs, it could have further to run and in recognition of that reality, everyone is talking about a triumphant return of the fabled bond vigilantes. Here’s Bloomberg’s Cameron Crise, for instance:

Price action in global bond markets, notably Treasuries, has been impressive in recent weeks. Bears have swatted away reasons to expect a pause in derisory fashion and sent yields soaring to levels not seen in several years. For a generation of traders who have never seen a real bear market in high-quality bonds, the relentless nature of the move may well be puzzling. It’s starting to look like the bond vigilantes of the 1990s, long thought dead and buried, may be making a comeback.

Let’s be clear: the secular forces of disinflation aren’t going away, so it is unrealistic to expect a return to the 1990s days of 8% 30-year Treasury yields. Moreover, the ECB and BOJ have made it pretty clear recently that they will lean against market expectations of premature tightening.

The bond vigilantes are still dead and buried. But that doesn’t mean that their zombies cannot return to haunt the market. They’ve already made short work of would-be dip-buyers over the last few days, and now seem intent on chasing the trend in 10-year Treasury yields to 3%.

Thanks to the bad optics (read: psychological distress) that would invariably accompany 10s at 3%, equity bulls (a group that, until last week anyway, apparently includes everyone), better hope Crise is wrong on that latter point.

This week didn’t let us down in terms of being batshit crazy and/or in terms of that craziness emanating from the jam-packed calendar for bond traders. We previewed that on Sunday evening in the somewhat prescient “If You Thought That Was Crazy“. That title was of course a reference to our contention that the manic moves in FX that characterized last week could end up looking tame by comparison to what might happen if any of the bond landmines ended up triggering a move even higher in yields and thus spooking equities. We even used Harley for the teaser image to underscore the point:

So you got “level 2” this week and what that entailed was a vicious (by post-crisis standards anyway) equity rout culminating on Friday with the worst day in percentage terms for the Dow since Brexit:

Of course the catalyst Friday was the AHE beat which seemingly validated concerns that inflation pressures are indeed building and it probably didn’t help that news of the swiftest wage growth since 2009 in the U.S. came just a day after PMI data out of Europe showed price pressures building materially across the pond.

The question now is what happens next or, more to the point, whether the combination of increased Treasury supply (thanks deficit-funded tax cut!), Fed balance sheet rundown, a fading of the downward pressure on long term U.S. yields occasioned by ECB normalization and traders testing the BoJ’s commitment, waning appetite from China, and the return of inflation could exacerbate the situation.

Beyond the obvious short-term impact a continuation of the bond rout would likely have in terms of knee-jerk reactions like we saw this week, it’s worth asking if the environment that’s kept risk premia compressed has really changed. This harkens back to the “shrinking playground” as articulated by Deutsche Bank’s Aleksandar Kocic (see here and here).

“While the long rate (Fed’s final destination) has moved higher, the shadow rate (short-term Fed expectations) have followed up in lockstep [and] the spread between the two remains roughly unchanged around 60bp,” he writes, in his latest note out Friday.

In other words, the playground hasn’t gotten any larger and in order for anything to happen, the Fed would have to decide to sit on its hands. For now, “the Fed remains in the lockstep with the economy, e.g. in terms of following r* at the ‘same distance’ as before,” Kocic adds.

Unless that changes, markets are stuck with what amounts to a binary option: jump on the carry boat or go the hell out of business waiting on something to happen. Here’s Kocic:

The figure below shows the history of the “Fed maneuvering space” (the spread between the long and the short rate) expressed as a range centered around zero. This range is compared with the residuals of the rates gamma onto other measures of risk premia in the market (IG spreads, FX vol, rates levels and curve risk premium). In the past, when the range was wide, the residuals were wide as well (typically trading the the 40bp range). However, as the Fed range compressed, carry became the only trade in town and different assets became interchangeable distinguished only by their ability to provide carry. In that environment the market players continued to arbitrage any dislocations until there was practically none left, with the vol residuals compressing to about a 10bp range.

Ok, so this leads naturally to questions about what could reverse the shrinking of the playground and for clues about that, simply refer back to the following two charts from another recent Kocic note:

So those dashed lines are stylized representations of a breakdown in the recent relationship between rates vol. (left pane), IG credit spreads (right pane) and breakevens. The question, basically, is what happens when the market begins to change its interpretation? What if the narrative around inflation changes and it stops being seen as an indicator of the viability of the recovery and rather as something that could potentially cause problems? Recall this tweet from Friday:

don't forget this from DB's Kocic:

Inflation cannot be allowed 2 develop because it would be no way of avoiding dramatic rise in rates. If Fed embarks on aggressive hikes rates would rise. If Fed stays behind, the market would bear steepen the curve. Either way, long rates go up

With that, we’ll simply close with one last excerpt from Kocic’s latest:

Higher rates mean moving closer to the tail risk strike. This could be achieved if rates rise is driven by higher breaekevens. This is the domain of negative convexity exposure of the central banks – a scenario that has no adequate policy response. Such an outcome would represent a choice between allowing rampant inflation with a possibility of either triggering a bond unwind trade or causing a stock market crash and possibly recession. Because of that, in the higher rates scenario, monetary policy would be a wild card.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice